November 5

Should Carleton's endowment be used to promote the college's values, or should it be managed to maximize return to better allow the college to accomplish its mission?

This is an extremely interesting question that Michael Hemesath addressed in the October 22, 2004 issue of the Carletonian. I have some thoughts I would like to add.

First, though, there is a bit of ambiguity in the question. Since the question ends with the clause referring to the investment management of the portfolio, I will assume that when the questioner asks, "Should Carleton's endowment be used to promote values," that the questioner means the "use of the endowment" to be in the investment management of the endowment portfolio rather than in any plan to use money from the endowment as contributions to social causes.

The question implies that the questioner assumes that managing the endowment to promote social values will decrease the returns from the endowment, or that applying a social screen to securities being purchased makes the portfolio less "aggressive." Let's look at this assumption. I will frame the discussion in terms of stocks since they are the most heavily traded investments, but the same concepts will hold for bonds as well.

The Efficient Market Hypothesis holds that openly and widely traded securities, such as stocks in the major American stock markets, are priced according to the information available at any given time. There is a formula for determining the value of a share of stock, known as the present value model, which is based on projecting future income and dividends and then discounting the income stream back to its value at the present time. As such, any of the stocks that an institution like Carleton is likely to invest in should be priced to produce total returns (income plus capital change) similar to other stocks available in the market at the time.

The Efficient Market Hypothesis has been found to be imperfect in some details, but generally it holds true for the vast majority of stocks most of the time. At a given point in time, each stock should be priced to provide a return equivalent to that of the market as a whole. There are many thousands of financial analysts and portfolio managers participating in the markets whose job is to identify undervalued stocks and buy them, and identify overvalued stocks and sell them. The net effect of the buying and selling should be to eliminate discrepancies in the equilibrium of equitably priced stocks. For most investors, the discrepancies due to pricing errors in the marketplace, and hence the opportunities to capitalize on or be hurt by pricing inefficiencies, are not significant.

It follows that the major industry groups should all be priced to reflect the general return expectation of the market as a whole, otherwise undervalued ones would be preferentially bought and overvalued ones would be preferentially sold. If the markets are reasonably efficient, then a portfolio diversified across all major industry groups should expect the same returns as the whole market, plus any value added by a portfolio manager and minus the expenses of running the portfolio.

If a portfolio invests in most (but not all) of the major industry groupings in the market, the return should still reflect the market return. For example, if a portfolio manager were to eliminate 10% of the stocks in the American markets as being socially unacceptable, that would still leave 90% of them available as potential investment vehicles. This should still provide more than ample opportunities for profits and diversification. If, on the other hand, the investor applied a more extreme social screen that ruled out 90% of the stocks, then the portfolio could become poorly diversified which could in turn lead to irregular investment results.

Two examples of institutional-scale socially aware portfolios are the TIAA-CREF Social Choice and the Vanguard Calvert Social Index mutual funds. They are broadly diversified, but they exclude investments in selected industries such as defense, tobacco, alcohol, gambling, and nuclear energy, as well as individual companies with poor human rights records in other industries. While they do eliminate some industries as acceptable investments, still they are widely diversified across most of the industry groups represented in the American stock markets. They should therefore still provide a return equivalent to the market as a whole, and in fact their performance records are fully competitive with other investment alternatives. Social screening of investments, when done in a responsible way, is essentially cost-free in terms of expected investment returns.

Anyone claiming that sensibly practiced socially aware investing will reduce the portfolio's returns should be questioned closely for the evidence behind their arguments. The chances are they either are arguing out of ignorance or they are trying to rationalize their biases. This was, however, the reason given by Carleton and many other institutions in the 1980's for not divesting themselves of stocks of companies that did business with the apartheid regime in South Africa.

Since employing social screening in choosing the college's investments should not reduce the college's expected portfolio returns, it therefore should not pose a barrier to the college's ability to carry out its educational mission. With respect to the question posed at the beginning of this essay, there need be no ethical choice that sets applying social investment screens against accomplishing the school's educational mission. Carleton should be able to employ socially aware screening in its portfolio management with no cost to the college or its educational program, should it choose to do so.

Choosing socially aware criteria for selecting stocks may be a daunting task as Prof. Hemesath suggests, but other institutions have addressed this question and resolved it to the satisfaction of many people. The Vanguard Calvert Social Index and the CREF Social Choice mutual funds are examples. One possible solution, if Carleton found itself struggling with the choices, would be to adopt either of these two mutual funds as investment choices. There are as well other socially screened investment choices offered by other investment firms that could be explored, but these two are among the best.